When a company acquires another company, any amount paid that's above and beyond the net asset value of the acquired company gets stuck on the acquiree's balance sheet as intangible assets. One class of intangible assets is goodwill, which isn't amortized and never expires. However, companies are required to assess the value of goodwill each year and mark it down if something has materially changed.
A massive write-off
This is the predicament that AT&T (T 1.30%) found itself in during the fourth quarter. The company has a long history of complicated mergers and acquisitions. AT&T traces its roots all the way back to Alexander Graham Bell and the invention of the telephone. The current iteration of AT&T, formed when SBC Communications merged with AT&T Corp. in 2005, is now a leader in both wireless and wireline communications.
This history has produced a staggering amount of goodwill sitting on AT&T's balance sheet. At the end of 2021, AT&T had $92.7 billion of goodwill, excluding goodwill that was shed from the spin-off of WarnerMedia last year. About half of the company's shareholder equity was tied up in goodwill at the time.
With a declining legacy wireline business and rising interest rates, AT&T's annual goodwill assessment led the company to take a $24.8 billion non-cash goodwill impairment charge in the fourth quarter. This brought AT&T's total goodwill down to $67.9 billion.
On top of this goodwill-related charge, AT&T took additional charges related to asset abandonment and restructuring. In total, the company recorded $26.8 billion in charges during the fourth quarter.
On a generally accepted accounting principles (GAAP) basis, these charges reduce earnings. AT&T reported a GAAP net loss of $23.6 billion, or a loss of $3.20 per share, during the fourth quarter.
Do these write-offs matter?
Goodwill impairment charges are a sign to investors that a company overpaid for an acquisition. They're not uncommon -- it's often the case that companies make overly optimistic assumptions about the benefits and cost synergies that an acquisition will deliver. When a company chronically writes down goodwill, that's a red flag for investors that the company is making bad capital allocation decisions.
In the case of AT&T, the massive goodwill impairment charge isn't a reason for concern. The write-off is tied to the company's legacy wireline assets. That business is going to largely disappear over time, replaced with the company's new fiber network. That goodwill was going to be written off at some point.
AT&T does have a recent history of goodwill write-offs that were problematic, but those are from its attempts to transform itself into a media conglomerate. The telecom giant wrote off $15.5 billion related to its acquisition of DirectTV in 2020, a clear sign that the company drastically overpaid. AT&T has since spun off DirectTV and exited its other media businesses.
Free cash flow is king
While AT&T's GAAP earnings are a mess thanks to these impairment charges, and its adjusted earnings are set to decline this year thanks to higher pension costs and a higher tax rate, the company is doing a good job generating cash. Ultimately, cash flow is what's used to pay the dividend and pay down debt.
AT&T generated around $14 billion of free cash flow in 2022, and it expects this number to rise to at least $16 billion in 2023. Non-cash charges don't affect free cash flow, so these write-offs won't have any impact.
With AT&T valued at roughly $140 billion, the stock trades for a price-to-free cash flow ratio below 9. The dividend is well covered by the company's cash flow -- the current quarterly dividend of $0.28 per share will require about $8.4 billion over the next year, a bit more than half of AT&T's expected free cash flow in 2023.
Big write-offs are something investors never want to see, but in the case of AT&T, that $25 billion hit to earnings doesn't change anything. AT&T stock looks like a great deal, and the company should be able to grow free cash flow in the years ahead as its investments in 5G and fiber pay off.
